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How the classification of lease is done.

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How can we classify the lease into finance lease or operating lease?

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Solution Summary

This solution discusses how to classify a lease into a financial lease or an operating lease.

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4.1 The classification of a lease as either a finance lease or an operating lease is critical as significantly
different accounting treatments are required for the different types of lease. The classification
is based on the extent to which risks and rewards of ownership of the leased asset are transferred
to the lessee or remain with the lessor. Risks include technological obsolescence, loss from
idle capacity, and variations in return. Rewards include rights to sell the asset and gain from its
capital value.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards of
ownership to the lessee. If it does not, then it is an operating lease. When classifying a lease, it is
important to recognize the substance of the agreement and not just its legal form. The commercial
reality is important. Conditions in the lease may indicate that an entity has only a limited exposure
to the risks and benefits of the leased asset. However, the substance of the agreement may indicate
otherwise. Situations that, individually or in combination, would usually lead to a lease being a finance
lease include

- Transfer of ownership to the lessee by the end of the lease term.
- The lessee has ...

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